Definition of fair value accounting

An alternative approach to measurement that seeks to capture changes in asset and liability values over time. The International Accounting Standards Board (IASB) defines fair value as "... an amount at which an asset could be exchanged between knowledgeable and willing parties in an arms length transaction".

Under the fair value measurement approach, assets and liabilities are re-measured periodically to reflect changes in their value, with the resulting change impacting either net income or other comprehensive income for the period. The result is a balance sheet that better reflects the current value of assets and liabilities. The cost is greater volatility in periodic reported performance caused by changes in fair value.

The notion of fair value accounting is intuitive when applied to quoted investments such as equities, bonds, commodities, etc. that are carried in an entity’s balance sheet at their market value. This form of fair value accounting is often termed mark-to-marketaccounting. However, while market prices are one aspect of fair value measurement, the term is increasingly being used to describe measurement by other means. For example, accountants often arrive at an estimate of fair value for non-quoted investments based on a model (e.g., a share option valued by applying a specialist option valuation model) or specialist opinion. Such applications of fair value measurement are referred to as mark-to-model accounting.

The IASB has followed US standard-setters in dealing with the problem of fair values that do not result from market prices. Specifically, IFRS 13 Fair Value Measurement applies the following valuation hierarchy:

Level 1: fair values are derived from quoted market prices for identical assets or liabilities from an active market for which an entity has immediate access

Level 2: where there are market prices available for similar (as opposed to identical) assets or liabilities

Level 3: if values for levels 1 or 2 are not available, fair value is estimated using valuation techniques

Fair value accounting is most frequently applied to financial assets and liabilities because market prices or reliable estimates thereof are most likely to exist for such elements. Proponents argue that fair value accounting for assets or liabilities better reflects current market conditions and hence provides timely information. Opponents, on the other hand, argue that fair values can be irrelevant and potentially misleading for a variety of reasons. For example, some claim that fair value is not relevant for items that are held for a long period (i.e., to maturity) as investors are not interested in interim value changes. Others argue that fair values can be distorted by market inefficiencies, investor irrationality or liquidity problems and that estimated values derived from models may lack reliability.

Finally, fair value accounting has been criticised for contributing to procyclicality in the financial system by exacerbating market swings and causing a downward spiral in financial markets. In particular, some commentators argue that emphasis on level 1 and 2 valuations makes it difficult to deviate from market prices, even if prices are below fundamentals or they give rise to contagion effects. [1]